Low inflation (luck) favors RBI!

In its third bi-monthly meeting for FY 2019-20, RBI’s Monetary Policy Committee (MPC) decided to cut the policy repo rate by an unconventional 35bps from 5.75 % to 5.4 %. Consequently, the reverse repo rate stands adjusted to 5.15 %, and the marginal standing facility (MSF) rate and the Bank Rate to 5.65 %. All members of the MPC unanimously decided to reduce the policy rate and to maintain the accommodative stance of the monetary policy, with four members voting in favor of 35bps cut and two members voting to reduce the policy rate by 25bps.

During the press conference, on being asked about the rationale for 35 bps cut, RBI Governor, Shaktikanta Das stated that 25bps cut might prove inadequate – 50 bps cut will be too much, whereas 35bps cut was viewed as a balanced decision by the committee. Governor also mentioned about the focus on filling the output gap and fading role of real rate framework in the current environment.

RBI has marginally revised its inflation and growth forecasts. Headline inflation for H2 2019-20 in June policy was projected in the range of 3.4-3.7 %, which is now changed to 3.5-3.7 % for H2, with risks, evenly balanced. GDP growth for FY2019-20 is revised downwards from 7.0 % in the June policy to 6.9 %. For H1 and H2 2019-20, real GDP growth was earlier projected in the range 6.4-6.7 %, and 7.2-7.5 %, which is now changed to 5.8-6.6 % for H1 and 7.3-7.5 % for H2 with risks somewhat tilted to the downside.

Our View

Various economic indicators are showing mixed signals with high-frequency lead indicators such as weak auto sales and sluggish rural demand (evidenced from FMCG corporate results) and dipping IIP & core sector growth nos. suggesting a slowing pace of growth in private consumption & capital expenditure. Whereas indicators such as domestic air traffic and July PMI data suggest an improving pace of expansion in the manufacturing and services sectors. Capacity utilisation saw an improvement in the March quarter; however, the number is expected to drop in June quarter on the back of a slowdown in major sectors such as Autos. Credit growth slowed to 12.1% in July, down from 16.2% growth recorded in Nov’18. Credit growth in the industrial sector has seen some improvement, though meager – reflecting a lack of demand and reduced bank appetite for corporate lending. Credit growth to medium, micro & small industries saw marginal recovery. Ongoing resolution of distressed assets and speeding up the implementation of stalled projects may help in broad-based credit recovery. Weak private demand and subdued investment activity have widened the output gap.

Government expenditure is expected to pick up with a focus on agriculture and the rural economy, supported by increased GST revenue, which is expected to rise by 18.2% (BE FY20). However, much of it is dependent on improvement in economic growth, better tax compliance & reduction in disputes.

Few risk factors are still pertinent such as volatile crude oil prices, uncertainty related to the monsoon, and concerns over fiscal slippage. Surprisingly (or maybe not!) RBI in its monetary policy statement has discontinued mentioning fiscal slippage as an upside risk factor. This concern has been a regular feature in their past statements. Adherence to the fiscal consolidation roadmap will be a critical task for the government as the slowing economy would sooner or later reflect in lower tax collections. This may result in increased reliance on disinvestment, small savings, and market borrowings to finance the fiscal deficit.

To an extent, this rate cut was already factored in by market as the participants were divided with an expectation of a 25bps or a 50bps cut in the policy rate. The yield on the 10-year benchmark G-sec which is down by more than 100 bps in the last three months, inched up 7bps post the policy announcement closing at 6.37%.

Accommodative monetary policy stance also leaves room with the RBI for further rate easing. Efficient transmission of the cumulative rate cuts since February 2019, leading to a reduction in lending rates is essential for a revival in credit flow so as to benefit the economy. Of course, a slew of other measures is required to spur private investment growth. Sufficient surplus liquidity should help in faster transmission of rate cuts by banks, although historically deposit rates have typically moved down faster than lending rates in falling interest rate cycles.

The central bank announced three additional measures to improve the credit flow to the NBFC sector. First, a bank’s exposure to a single NBFC is increased to 20% of Tier-I capital of the bank, up from 15%. Second, increasing bank lending limits to NBFCs for on-lending to the priority sector. Third, reduction in risk weight for consumer credit including personal loans but excluding credit card receivables to 100% from 125% or higher if warranted by the external rating of the counterparty.

What do our Valuation Implied Return (VIRs) forecasts for fixed income indicate?

The recent rally has brought down our 10-year valuation implied return forecasts for Long-term debt. Based on our valuation-driven asset allocation approach, Medium-term debt offers a relatively attractive spread over the fair value estimates as compared to Short and Long-term debt within the Indian fixed income basket.

How have we positioned our Managed Portfolios?

On the debt side, last month, we brought back our overweight position in Long-term Debt to benchmark or neutral level across all four portfolios. With that, we are now overweight Short and Medium-term debt, amid attractive real rates. Given that equity valuations are looking stretched, we are holding more cash than what neutral allocations suggest. This should provide ammunition when attractive investment opportunities arise and offer further downside protection, although the prolonged correction in small-cap equities has got us to rethink our underweight position.

We are not proposing any other changes to the underlying holdings at this time, as we believe the composition of the Portfolios remains appropriate for the prevailing conditions. We continue to monitor the portfolios closely and stay focused on helping investors achieve their goals over the long term.